What is Diversification
Diversification is all about spreading your risk. If you have a large investment portfolio, you may decide to spread out your risk by diversifying. People diversify to protect themselves from catastrophes, such as huge market sell-outs, that way they don’t lose everything.
Many times if a stock is going to fail, you can’t get out of your position fast enough…or if you have a large holding and try to sell, you bring the market even lower. This is where diversification can be helpful – it’s about minimizing your risk.
What Does Diversification Look Like?
Let me give you an example:
Let’s say you have a glass bowl with 3 pieces of candy in it. The glass bowl represents your portfolio. Now let’s add a tomato. We just diversified our bowl (i.e., portfolio) by adding something different from candy. Now let’s add an apple…our bowl is now even more diversified.
Let’s say each of these things represents how we diversified, say a technology company like Apple, Inc., a food company like Hershey’s and an agricultural company like Monsanto. We have a diverse group of stocks in our portfolio bowl.
Next, when looking at our bowl we should consider what will spoil first. Chances are, the tomato would go rotten before the candy would and so would our apple. When looking at your portfolio, consider which companies will spoil first – those are the ones to get out of. Even if your tomato spoils completely on you and you miss out on enjoying it, you still have your candies and your apple to fall back on.
If one of your companies is very profitable, you may want to take a piece out, like taking a chocolate out of our bowl, and cash in on some of your profits.
Diversification helps keep your portfolio safer.
When Should You Diversify?
The key to diversification is knowing your risk and adjusting your portfolio accordingly. If your portfolio is smaller than 50 or 100 thousand, diversification can become a little bit tricky.
Remember: If you have less than $100,000 in your portfolio, I recommend you only trade 5 different positions. It will help you focus better on what you have and keep you from making mistakes by spreading yourself too thin.
In the case of a smaller portfolio, you may want to ask yourself, “What will last the longest?” In our example above, the candy would last the longest. So you may want to buy more of that stock and if you decide to diversify, you may want to add just one more thing if your portfolio is smaller than $100,000.
Let’s say you keep the tomato (a more volatile stock) in your bowl. As long as you’re keeping a constant watch on it, you can get great returns on it. But the moment you start to see bad spots or mold, you’ll want to get out of that stock.
Diversification is a great tool and will help you reduce your risk.